Stick or Twist?
We’re hearing the clarion call of market timing ever more loudly. It’s unsurprising that this is the case – in times of almost unprecedented market volatility many people have suffered a horrible rude awakening about the true nature of stockmarket risk. By some measures markets have now returned the square root of bugger all for the best part of four decades.
Despite this we need to be careful that the alluring song of the naysaying sirens doesn’t blind us to the real meaning of risk. While passive investment can clearly be outperformed by people with time and money it’s not necessarily the safest way of proceeding if you don’t know what you’re doing.
And, to be frank, that’s most of us.
Anti-Tracker Bias
The idea that passive long-term buy and hold investing isn’t safe has been gaining rapid currency - as has the argument that the simple market capitalisation weighted index tracker is not just inefficient but is one of the causes of the current market convulsions. By tracking the most popular rather than the best value stocks, it’s been suggested that standard index trackers have exaggerated the market overvaluation and been responsible for many people putting their money into the wrong stocks at the wrong time.
However, before we accept this uncritically we need to baseline our thinking. Much of the anti-tracker bias is qualitative rather than quantitative. On a qualitative basis the proponents of alternative investment strategies need to explain how people with little or no understanding of the markets can invest safely for their retirement, not simply point out that their existing strategy is flawed.
The alternative argument, by market professionals, would seem to be that they should put their faith in market professionals. Unfortunately, this idea has been undermined time and again by the actions of those in positions of authority: put not your faith in the securities industry until it reforms itself from within. So here we sit on the horns of a dilemma – if passive investing doesn’t work and active investing requires professional advice that we can’t trust what the hell do we do?
Let’s look at a few numbers.
Vanguard’s Performance
Looking at the history of the flagship market cap index tracker, the Vanguard 500, going way back to 1976, we can come up with a few estimates about the baseline return for a know-nothing and do less investor. These figures aren't precise, but they're in the right ballpark.
If you’d started investing in Vanguard back in 1976, putting aside $100 a month after fees (which we'll ignore, safe in the knowledge that they've always been just about the lowest around) and reinvesting dividends tax free you’d now have a nest egg of about $170,000 at an annual growth rate of just under 8% having imvested just less than $40,000 over the 33 years or so you’ve been saving. To put that in persepective, $40,000 in 1976 would now be worth about $150,000 in inflation adjusted buying power - although $40,000 invested in the fund in 1976 with dividends reinvested would be worth well over three times that.
There's a few points worth drawing out here. Firstly, with investing it pays to start early. Secondly it pays even more to reinvest your dividends: this roughly doubles the return on the investment for our monthly dollar-cost averaging investor. Thirdly investing in stocks is, in the long term, a reasonable hedge against inflation. Fourthly, shelter everything you can from tax, the effects of compounding work both ways.
This isn’t a contrafactual argument about what you might have done had you selected the right investment all those years ago. It didn’t require you to sit down with a pin and a copy of the Wall Street Journal and hit the jackpot by luck. It simply required a basic decision to invest in the lowest cost investment around and to keep on investing small amounts of money regardless of what was happening out in the markets. It was, and remains, an invest and forget strategy.
Baselining the Argument
This is our baseline: this is the basis against which all other investment strategies must be judged. A simple, easily achievable approach which allows the investor to ignore the details and difficulties of stock investment. You know; stuff like regular market crises, the psychological convulsions of the participants, the perfidy of the practitioners, the excess fees of mutual funds and the incompetence of the regulators. Alternatives need to show how they can generate better returns than this at lower risk, not simply argue that the strategy is wrong.
Consider also the ebb and flow of the markets. It’s no mistake that the sudden burst of anti-tracker syndrome has occurred at the market bottom. But it’s not just a market bottom – it’s the worst bust in the best part of a century, the Omega Point at which every evil doer that ever was gangs up on us and launches a battle for market dominion. To judge returns at this point based on contrafactual evidence that we could have done better had we been clairvoyant is, at best, a dubious practice and, at worst, a deliberate attempt to induce fear, doubt and uncertainty.
Nor, of course, does it give us the faintest clue about the shape of the next forty years. But it might generate some more fees for someone.
When Volatility Matters
We can see the ups and downs of the markets by examining, once more, the returns on the Vanguard 500. For most of the 1980’s our investor’s return wobbled around 8% or 9%, taking off in the 1990’s and rising to an astonishing 14% in 1999 and 2000. The annual growth rate has since slipped back, falling back into single figures in 2007 and below 8% early this year.
To get a feel for the possible impact of market timing consider that our long-term investor’s return peaked at over $250,000 at the back end of 2007 before falling to less than half of that in early 2009. In March 2009 the nest-egg’s value dropped to a level not seen since 1997. Now, however, we’re already back to early 2004 values.
That’s market volatility for you and that’s why Markowitz equated volatility with risk. But it’s only a risk if timing matters to you.
The Omega Point
For our know-nothing, do nothing, remain passive investor this only matters at one point – the point at which the investment nest-egg is required to supplement retirement income. Just as the dumb investor needs to take market timing out of the equation as regards investing so they need to do so when it comes to retirement. To have to retire at the Omega Point is the definition of Hell on Earth and it’s for this reason that investment income is critical. Our $100 a month investor would have an income of around $4000 a year from their Vanguard shares: not nearly enough to survive on while waiting for the upturn.
The solution to this, obviously, is to invest more than a hundred bucks a month and perhaps to diversify into bonds. The oft-quoted rule that you should be in bonds to the percentage of your age – 60% bonds at age 60 – isn’t a bad one for this reason. It also promotes the idea of slowly moving from equities into bonds, rather than making a sudden shift.
Dumb Strategies Need Time
None of this is to argue that the doomsayers are completely wrong: it’s clearly possible for some people to outperform market cap based index trackers. However, given that we’re at or near the Omega Point and that a very long term, dumb strategy can still yield sufficient money to allow a comfortable retirement it’s questionable whether it’s necessary for investors to take the risks associated with alternative approaches.
Bluntly, most people don’t know how to invest: to do so effectively you need some understanding of the workings of the markets, a good grasp of psychology, emotional control and the ability to read and analyse a set of accounts. Until such time as these skills are taught to our children we can assume that the average investor is exposed to all of the dangers that lurk in the undergrowth of the markets.
Diversify and Rebalance
The best answer to this is a simple, well structured portfolio: half a dozen index trackers of various kinds balanced across geography and asset classes, occasionally rebalanced to move away from the more overvalued areas. Minimal effort, maximal returns: better still, it means people can get on with their lives instead of wasting it chasing assets around in a desperate attempt to generate returns. When people start spending more time focusing on financial speculation than they do on the creation of real value through their labour and intellect the world is apt to go wrong. Most of us are better off trying to generate the income to invest with than trying to figure out how to invest.
The alternative is to revisit the Omega Point time and again. Best to get on with our lives rather than worrying about what markets are doing.
Related Articles: Jack Bogle and the Bogleheads, It's OK to Lose Money, It's Not Different This Time
We’re hearing the clarion call of market timing ever more loudly. It’s unsurprising that this is the case – in times of almost unprecedented market volatility many people have suffered a horrible rude awakening about the true nature of stockmarket risk. By some measures markets have now returned the square root of bugger all for the best part of four decades.
Despite this we need to be careful that the alluring song of the naysaying sirens doesn’t blind us to the real meaning of risk. While passive investment can clearly be outperformed by people with time and money it’s not necessarily the safest way of proceeding if you don’t know what you’re doing.
And, to be frank, that’s most of us.
Anti-Tracker Bias
The idea that passive long-term buy and hold investing isn’t safe has been gaining rapid currency - as has the argument that the simple market capitalisation weighted index tracker is not just inefficient but is one of the causes of the current market convulsions. By tracking the most popular rather than the best value stocks, it’s been suggested that standard index trackers have exaggerated the market overvaluation and been responsible for many people putting their money into the wrong stocks at the wrong time.
However, before we accept this uncritically we need to baseline our thinking. Much of the anti-tracker bias is qualitative rather than quantitative. On a qualitative basis the proponents of alternative investment strategies need to explain how people with little or no understanding of the markets can invest safely for their retirement, not simply point out that their existing strategy is flawed.
The alternative argument, by market professionals, would seem to be that they should put their faith in market professionals. Unfortunately, this idea has been undermined time and again by the actions of those in positions of authority: put not your faith in the securities industry until it reforms itself from within. So here we sit on the horns of a dilemma – if passive investing doesn’t work and active investing requires professional advice that we can’t trust what the hell do we do?
Let’s look at a few numbers.
Vanguard’s Performance
Looking at the history of the flagship market cap index tracker, the Vanguard 500, going way back to 1976, we can come up with a few estimates about the baseline return for a know-nothing and do less investor. These figures aren't precise, but they're in the right ballpark.
If you’d started investing in Vanguard back in 1976, putting aside $100 a month after fees (which we'll ignore, safe in the knowledge that they've always been just about the lowest around) and reinvesting dividends tax free you’d now have a nest egg of about $170,000 at an annual growth rate of just under 8% having imvested just less than $40,000 over the 33 years or so you’ve been saving. To put that in persepective, $40,000 in 1976 would now be worth about $150,000 in inflation adjusted buying power - although $40,000 invested in the fund in 1976 with dividends reinvested would be worth well over three times that.
There's a few points worth drawing out here. Firstly, with investing it pays to start early. Secondly it pays even more to reinvest your dividends: this roughly doubles the return on the investment for our monthly dollar-cost averaging investor. Thirdly investing in stocks is, in the long term, a reasonable hedge against inflation. Fourthly, shelter everything you can from tax, the effects of compounding work both ways.
This isn’t a contrafactual argument about what you might have done had you selected the right investment all those years ago. It didn’t require you to sit down with a pin and a copy of the Wall Street Journal and hit the jackpot by luck. It simply required a basic decision to invest in the lowest cost investment around and to keep on investing small amounts of money regardless of what was happening out in the markets. It was, and remains, an invest and forget strategy.
Baselining the Argument
This is our baseline: this is the basis against which all other investment strategies must be judged. A simple, easily achievable approach which allows the investor to ignore the details and difficulties of stock investment. You know; stuff like regular market crises, the psychological convulsions of the participants, the perfidy of the practitioners, the excess fees of mutual funds and the incompetence of the regulators. Alternatives need to show how they can generate better returns than this at lower risk, not simply argue that the strategy is wrong.
Consider also the ebb and flow of the markets. It’s no mistake that the sudden burst of anti-tracker syndrome has occurred at the market bottom. But it’s not just a market bottom – it’s the worst bust in the best part of a century, the Omega Point at which every evil doer that ever was gangs up on us and launches a battle for market dominion. To judge returns at this point based on contrafactual evidence that we could have done better had we been clairvoyant is, at best, a dubious practice and, at worst, a deliberate attempt to induce fear, doubt and uncertainty.
Nor, of course, does it give us the faintest clue about the shape of the next forty years. But it might generate some more fees for someone.
When Volatility Matters
We can see the ups and downs of the markets by examining, once more, the returns on the Vanguard 500. For most of the 1980’s our investor’s return wobbled around 8% or 9%, taking off in the 1990’s and rising to an astonishing 14% in 1999 and 2000. The annual growth rate has since slipped back, falling back into single figures in 2007 and below 8% early this year.
To get a feel for the possible impact of market timing consider that our long-term investor’s return peaked at over $250,000 at the back end of 2007 before falling to less than half of that in early 2009. In March 2009 the nest-egg’s value dropped to a level not seen since 1997. Now, however, we’re already back to early 2004 values.
That’s market volatility for you and that’s why Markowitz equated volatility with risk. But it’s only a risk if timing matters to you.
The Omega Point
For our know-nothing, do nothing, remain passive investor this only matters at one point – the point at which the investment nest-egg is required to supplement retirement income. Just as the dumb investor needs to take market timing out of the equation as regards investing so they need to do so when it comes to retirement. To have to retire at the Omega Point is the definition of Hell on Earth and it’s for this reason that investment income is critical. Our $100 a month investor would have an income of around $4000 a year from their Vanguard shares: not nearly enough to survive on while waiting for the upturn.
The solution to this, obviously, is to invest more than a hundred bucks a month and perhaps to diversify into bonds. The oft-quoted rule that you should be in bonds to the percentage of your age – 60% bonds at age 60 – isn’t a bad one for this reason. It also promotes the idea of slowly moving from equities into bonds, rather than making a sudden shift.
Dumb Strategies Need Time
None of this is to argue that the doomsayers are completely wrong: it’s clearly possible for some people to outperform market cap based index trackers. However, given that we’re at or near the Omega Point and that a very long term, dumb strategy can still yield sufficient money to allow a comfortable retirement it’s questionable whether it’s necessary for investors to take the risks associated with alternative approaches.
Bluntly, most people don’t know how to invest: to do so effectively you need some understanding of the workings of the markets, a good grasp of psychology, emotional control and the ability to read and analyse a set of accounts. Until such time as these skills are taught to our children we can assume that the average investor is exposed to all of the dangers that lurk in the undergrowth of the markets.
Diversify and Rebalance
The best answer to this is a simple, well structured portfolio: half a dozen index trackers of various kinds balanced across geography and asset classes, occasionally rebalanced to move away from the more overvalued areas. Minimal effort, maximal returns: better still, it means people can get on with their lives instead of wasting it chasing assets around in a desperate attempt to generate returns. When people start spending more time focusing on financial speculation than they do on the creation of real value through their labour and intellect the world is apt to go wrong. Most of us are better off trying to generate the income to invest with than trying to figure out how to invest.
The alternative is to revisit the Omega Point time and again. Best to get on with our lives rather than worrying about what markets are doing.
Related Articles: Jack Bogle and the Bogleheads, It's OK to Lose Money, It's Not Different This Time
The choice is not between stock picking (which requires more expertise than many middle-class investors possess) and passive investing. How about investing in indexes rationally (that is, taking valuations into consideration when making allocation decisions)?
ReplyDeleteThat's a simple way to invest and one that protects investors from most of the risks of stock investing.
Rob
I don't think the article is saying that the only choice is between stock picking and passive investing. Some criticism of passive is coming from those who advocate decisions about timing switches between asset classes.
ReplyDeleteMarket-timing a switch between asset classes is surely not a passive approach (and hence is rightly set up in opposition to passive investing), but it does not require segregated portfolios of shares, bonds or whatever, still less an active approach to the management thereof.
To continue the train of thought of the article, if switching between asset classes is to be considered, can it be done in a simple mechanistic way that adds value? i.e. how does the average Joe who uses index trackers to get exposure to his chosen asset classes do asset class switching in a way that is consistent with his knowledge, skill and level of engagement? The share index "valuation" techniques I know of need too much info, too much brain power, too much compute power and too much time to fit this scenario.
As a side observation, I think the language is lacking. We talk of "passive" investing as though it applied only to the management of a holding in a single asset class - classically of shares. Seems to me that we can have pasive investing on at least two levels: intra-asset-class (e.g. equity index tracker) and inter-asset-class (e.g. do nothing (ltbh), or a simple periodic cut-and-fill rebalancing strategy). We don't (yet) have good ways to mark this kind of distinction, do we?
BTW: If active investing is too complex for the average Joe to use and make work, but passive investing isn't, how come the vast majority of average Joes still don't use passive investing? Must be that the case for passive is *still* too complex for them to get (and be confident of), mustn't it?
This ignores income taxes and inflation.
ReplyDeleteSince I can't really ignore them does this investment
scheme really work for retirement?
In saving today you have a choice of avoiding two of the following:
- taxes
- inflation
- risk
Actual saving requires avoiding all three.
Without inflation and taxes the small investor has no
reason to be in the stock market (or any fancy financial products).
He should be just in cash, or possible some really
secure bonds. Saving over a lifetime can easily support a reasonable retirement. Under these conditions financial planning is trivial.
The major push into the stock market is due to the pressure from inflation and taxes -- bonds are a certain loss if not a wipeout. The stock market
might not be much better than bonds after inflation,
taxes and some amount of bankruptcies.
I'm not suggesting that passive investing is "best" (or not) merely that the baseline achieved by dollar-cost averaging into a standard index tracker over a long period is the baseline against which other investment strategies should be analysed, with volatility thrown into the mix. The problem with other strategies is that they generally require financial advice which is increasingly mistrusted.
ReplyDeleteHowever, the argument that people aren't even rational enough to invest this way is quite valid - I've just been reading a UK government paper that shows 1 in 7 people regard the lottery as a key part of their financial planning. So what do you do?
So what do you do?
ReplyDeleteMy view is that what we need to do is to educate people, timarr.
Say that we taught people how to drive by explaining that the speed at which you drive makes no difference and that we reinforced that message daily by advising people that the key to safe driving is always to ignore posted speed limits. There would be a lot more accidents, right?
That's what we do in the investing field. The most important thing to get right is the asset allocation. Yet The Stock-Selling Industry has directed hundreds of millions of dollars to marketing campaigns telling people that there is no need for them to change their stock allocations in response to price changes. When people hear something repeated thousands and thousands of times, they come to believe that there is something to it. That's why we are in the economic crisis we are in today.
We should be giving people accurate and realistic investing advice. The first rule is that the key to long-term success is setting your stock allocation properly. The second rule is that, to do that, you must be willing to adjust your allocation as needed in response to changes in valuation levels.
The widespread promotion of Passive Investing is the reason why so few middle-class investors are able to invest effectively or even to engage in rational discussion of the investing realities. We all need to get to work building a model that works (I call the non-Passive model "Rational Investing").
Rob
Rob - great thoughts. From my experience as a financial planner the education won't work on its own. Individual's irrationality will override almost all education attempts unless the education is coupled with a serious and perhaps cumbersome obstacle to acting on their irrationality.
ReplyDeleteA passive investment approach with two important features is what we need for the average investor. These two features would automatically adjust (quarterly?) the asset mix between fixed income and equities based on the individuals planned withdrawal commencement date and overall stock market valuation based on trailing P/E10 and perhaps a measurement of P/B as well. Tie those features into a simple product with a cumbersome exit strategy (perhaps requiring the individual to list 3 pros and 3 cons of the proposed action - buy or sell) and it may just work to counteract many individual's tendency to act irrationally.
Thoughts?
I think that's sounds promising, Mohican.
ReplyDeleteI don't think it's necessary to make an allocation shift quarterly. My view is that only significant changes in the P/E10 level require a change, and we can go for years without seeing significant changes. But I view it as essential that the point be made firmly and clearly that allocation changes are required for the long-term investor. Without allocation changes, investor risk profiles are bouncing all over the place and that's just not a healthy situation. We need to put in place mechanisms to stress to investors that they must time the market (only in a long-term sense, certainly not in a short-term sense) if they are to have any realistic hope of long-term success.
Rob
In line with Mohican's thoughts there's a lot of evidence that financial education doesn't make a huge difference to people's approaches. Automation of the process is essential, but you can also run into issues around personal freedom and choice. The risk with any wide scale mechanical program, of course, is that it becomes an exploitable bias in its own right.
ReplyDeleteOn long-term timing there's a balance between costs and incremental gain but I've seen suggestions on anything between annually and every five years. More research needed.
On the education thing I'm currently researching an article. It's surprising stuff, as usual when people and money are involved.
I'm curious ... is there a reliable place to get current and historical index valuations (P/E, P/B, etc.)?
ReplyDeleteVM
is there a reliable place to get current and historical index valuations (P/E, P/B, etc.)?
ReplyDeleteThere are. But there is not agreement on what constitutes "reliable." People with different viewpoints are going to point you to different places.
I believe that P/E10 (the price of a broad index over the average of the earnings for the past 10 years) is the best valuation metric. I have a podcast at my site ("P/E10 Rules!") that explains why. But people who don't pay much attention to valuations often cite P/E1 (the more popular valuation metric) to show that valuations are not as important as those who focus on valuations say they are. This causes a lot of confusion because P/E1 gives a lot of false reads.
My point is that I would advise you to focus on P/E10 and I would not consider any site that focuses on P/E1 "reliable." But others would offer a very different take. Ultimately, the question of who is "reliable" is something that the investor needs to decide for himself or herself.
There is a lot more subjectivity to ALL investing questions that those who try to portray investing as a "science" let on.
Rob
Timarr, I'm curious as to why you think educating the populace would improve overall investment returns?
ReplyDeleteIf everyone benefits from something, then surely it's netted out?
You'd still get volatility set by whatever actors were still running more active strategies at the margin, I suspect?
And over 30 years, our educated people's returns would still be the same - they'd just have been less worried.
Having said that I suppose they could have given less to the financial industry along the way... ;)
Hi Monevator
ReplyDeleteTo be precise I don't think education helps very much, but that's not a personal opinion but the result of rather a lot of research. More soon ...
Hi Rob,
ReplyDeleteThanks for your comments on P/E10. I'll check out the podcast.
VM
I'm a beginner investor...
ReplyDeleteMy plan is to invest in one of the FTSE ALL Share index trackers, with monthly payments over the next 30 years or so. However, as soon as the next (inevitable) 'crash' happens in 10 years or so, I'll simply take the money out, wait 6-8 months for the recovery to kick in and then re-invest it. My plan sounds so simple, it can't go wrong? Can it?
discuss